Figuring Out ECRI’s Recession Call

I am writing this post in response to the article “Why Our Recession Call Stands” of March 15, 2012 by Lak­sh­man Achuthan and Anir­van Banerji of the Economic Cycle Research Institute (ECRI).

ECRI said: “How about forward-looking indi­ca­tors? We find that year-over-year growth in ECRI’s Weekly Lead­ing Index (WLI) remains in a cycli­cal down­turn (top line in chart) and, as of early March, is near its worst read­ing since July 2009. Close observers of this index might be under­stand­ably sur­prised by this per­sis­tent weak­ness, since the WLI’s smoothed annu­al­ized growth rate, which is much bet­ter known, has turned decid­edly less neg­a­tive in recent months. The unusual diver­gence between these two mea­sures of growth under­scores a wide­spread sea­sonal adjust­ment prob­lem that econ­o­mists have known about for some time.”

The last sentence of the above paragraph must be treated with some circumspection. What they call “the unusual divergence” is in my opinion nothing but a mathematical divergence. Let me take you through their calculation of the smoothed annualized growth rate as I figured it out. ECRI calculates a linear smoothed time-weighted index for every week based on weekly WLI values over the past 52 weeks, where each following week carries proportionately more weight than the previous week. The weekly percentage change of the time-weighted index is then calculated and annualized. My calculation of the WLI smoothed annualized growth rate is virtually a perfect fit of that of ECRI with an r-squared of 0.99.

Sources: ECRI; Plexus Asset Management.

It is therefore plain logic that the WLI smoothed annualized growth rate will lead the WLI year-over-year growth rate.

Sources: ECRI; Plexus Asset Management.

It follows that even if the smoothed annualized growth rate starts to fall in coming weeks the year-over-year growth rate will start to turn less negative.

ECRI also commented that “In spite of the efforts of mon­e­tary pol­icy mak­ers, actual U.S. eco­nomic growth has slowed, while WLI growth has barely budged from a two-and-a-half-year low.”

In previous calls ECRI emphasized the smoothed annualized growth rate of the WLI but its focus has clearly changed to the year-on-year growth rate. Will the improved year-on-year growth rate of the WLI in coming weeks change their mind and cause a big hooray about ECRI‘s change in stance or are they hoping or wishing for a major fall in the markets? It would seem the “unusual divergence” ECRI refers to and its change in focus to year-on-year growth from smoothed annualized growth are used to substantiate their call on the economy, whether it may turn out to be right or wrong.

ECRI also said “It is notable that the WLI, which is sen­si­tive to the prices of risk assets that have been sup­ported by mas­sive world­wide liq­uid­ity injec­tions, has hardly been swayed from its reces­sion­ary tra­jec­tory.”

In analyzing the WLI I concentrated on three major assets, namely the S&P 500, US 10-year Government Bond Yield and the Economist Metals Index. My analysis indicates that ECRI again focused on year-on-year growth rather than on smoothed annualized growth rates when they made the statement.

The U.S. stock indices may have a major impact on the calculation of the WLI. This is evident when the year-on-year growth of the S&P 500 Index is compared to that of the WLI. The growth rate of the S&P 500 Index bottomed at zero percent and is on the rise. This should impact positively on the WLI.

Sources: ECRI; I-Net; Plexus Asset Management.

The smoothed annualized growth rate of the S&P 500 Index is clearly exerting upward pressure on the smoothed annualized growth rate of the WLI.

Sources: ECRI; I-Net; Plexus Asset Management.

The prices of materials could have a major impact on the WLI and the Economist Metals Index is probably a good proxy for the prices of materials. The year-on-year growth rate of the Metals Index is currently impacting negatively on the year-on-year-growth rate of the WLI.

Sources: ECRI; I-Net; Plexus Asset Management.

The smoothed annualized growth rate of the Economist Metals Index is clearly exerting upward pressure on the smoothed annualized growth rate of the WLI.

Sources: ECRI; I-Net; Plexus Asset Management.

The U.S. bond market could have a major impact on the WLI and the 10-year Government Bond Yield is probably a good proxy for the U.S. bond market. The year-on-year growth rate of 10-year bond yield index is currently impacting negatively on the year-on-year-growth rate of the WLI.

Sources: ECRI; I-Net; Plexus Asset Management.

The smoothed annualized growth rate of the 10-year bond yield is clearly exerting upward pressure on the smoothed annualized growth rate of the WLI.

Sources: ECRI; I-Net; Plexus Asset Management.

It would seem that the WLI isin factcurrently swayed AWAY “… from its reces­sion­ary tra­jec­tory” (ECRI’s quote), especially due to the fact that the smoothed annualized growth rates lead year-on-year growth rates.

ECRI said: “The unusual diver­gence between these two mea­sures of growth under­scores a wide­spread sea­sonal adjust­ment prob­lem that econ­o­mists have known about for some time.”

I assume the “wide­spread sea­sonal adjust­ment prob­lem” ECRI refers to is the markets’ reaction to the seasonal adjustments that per se influence the WLI. Surely, similar previous reactions or, put differently, price and yield movements due to adjustments, have been taken into account in all the data series and were included in ECRI’s previous calls?

I am an investment professional and not an economist and regard the WLI and ECRI’s calls on the economy of great value and indispensable. Whether I agree or disagree with their current recession call is not the point, but I urge them to stick to the original interpretation of their WLI and not to be selective in the interpretation that may be viewed as justifying their view on the economy. After all, markets are extremely well informed and their anticipation of future economic trends is nearly perfect, hence the construction of ECRI’s WLI and the great value it offers to non-economists.

One Response to "Figuring Out ECRI’s Recession Call"

I was also initially surprised by their recession call last year. I find the weekly movements of the WLI to be too noisy. If you average the data to quarterly, the historical WLI has a perfect record in forecasting the last 7 recessions, with no false alarms. But here's the trick: the key threshold to signal a recession in the quarterly yoy growth rates is -4%. Every time the yoy has dipped below -4% growth since 1967, there has been a recession. Try it, you'll see.

When ECRI made their recession call last year, the yoy growth hadn't crossed that threshold so I wasn't personally expecting a recession. Based on today's data, however, the yoy growth in 2012Q1 is -4.4%, which would signal a recession based on historical experience. I'm not convinced that this will actually play out, given other indicators, but I'm curious to see how events unfold.